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Mezzanine capital is a broad financial term that refers to unsecured, high-yield, subordinated debt or preferred stock. Mezzanine capital represents an intermediary between equity and debt in a company’s balance sheet, as the following chart illustrates:
Due to increased credit risk, mezzanine capital is a relatively expensive financing source for a company. For this reason, it is mainly appropriate for financing growing companies with high profitability. One reason a company might prefer mezzanine capital is to maintain its equity ratio. Even loan-oriented mezzanine instruments are often valued as commercial equity.
Whether mezzanine capital is classified as equity or debt depends on three factors:
Variations also occur because of different accounting rules, such as IFRS and the German Accounting Rules (HGB).
In Germany the silent partnership is the classic form of mezzanine financing. There are two main types: the typical silent partnership and the atypical silent partnership.
The silent partner contributes a share of the capital and obtains a share of the profit in return. The participation in losses is typically limited to the capital contribution, but can be higher in atypical partnerships.
The typical silent partner does not influence the management of the company and expects a minimum rate of return on a regular basis (usually yearly). By comparison, participation in management and risk is an inherent part of the atypical silent partnership, and for this reason, the atypical silent partner demands an extraordinary return.
The typical silent partnership widely used in public funding. Public venture capital companies (Innovations- und Technologiebeteiligungsgesellschaften) or public-private equity enterprises (Mittelständische Beteiligungsgesellschaften) take minority shares in technological ventures or growing SME.
The subordinate loan, also known as a junior tranche, is a debt instrument that takes a lower re-payment priority than the normal debt provided by lenders. In the event of default, the repayment is subordinated and all other lenders are re-paid first.
Subordination also refers to the payment of amortization and the provision of securities.
With regards to securities, subordination means that banks do not require collaterals for these loans. However, the advantages over normal debt for the creditor are combined with a higher risk for the bank. These risk factors must be covered with a higher margin, which means higher interest rates for the borrower.
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